What is Monetary Policy?

Definition: Monetary policy is the method of controlling the supply of money in a particular economic area with the aim to ensure price stability and confidence in the currency for a given level of inflation rate or interest rate.

What Does Monetary Policy Mean?

A monetary policy is implemented to control inflation, unemployment, and foreign exchange rate. This method can be expansionary, which encourages economic development boosting inflation, or contractionary, which restricts or depresses the amount of money in the market curbing inflation.

The main instruments that a government or central bank uses are classified into direct controls and market-based controls. Direct controls include guiding lending lines imposed per bank, administrative controls on the interest rate level and the margin between the retail and the wholesale banking rates, rediscount quotas of bank portfolios and moral persuasion. Market-based controls include interventions in the open market through repurchase agreements (repos), discount rate, and reserve requirements.

Let’s look at an example.

Example

The main objective of a central bank is to maintain price stability through sustaining low inflation. Let’s look at a few different examples to see who benefits from high inflation.

Jerry is a freelance photographer. He may earn $2,000 in one month and $500 in another. Mark is a book vendor. He may sell 50 books in one month and earn $500 or sell 80 books in another and earn $800. Both Jerry and Mark have a flexible income, and they are both able to readily adjust their fees depending on the market conditions. Therefore, they are not influenced by a high inflation. High inflation is also beneficial to borrowers who see their debt getting lower in real value as high inflation prevails. The same goes for national governments as the debt may be increasing due to higher interests, but it is paid off at a lower real value.

Michelle works in a factory and earns $800 per month. Mariam works in Law Company and earns $1,200 per month. Adrianna is retired and gets a pension of $2,200 per month. Michelle, Mariam, and Adrianna get a fixed income and they see their income being drastically affected by high inflation. They cannot save any money and they cannot spend affluently. Therefore, a high inflation affects fixed income and the main objective of a central bank is to protect low-income consumers. High inflation is also affecting creditors who see their loan repayments getting lower as high inflation prevails.